Evaluating Profit Projects

Evaluating components of an investment program for a company is complex at any time. There are many categories of investment: (1) revenue-producing projects, (2) supporting facilities projects, (3) supporting services projects, (4) cost-savings projects, and (5) investments required to comply with public authority that will yield no return. Each must be evaluated to determine its incremental consequence.

When a project is isolated from the rest of the operation, evaluation is relatively clear. But sometimes a planned major investment embraces several auxiliary projects which, evaluated by themselves, are not very meaningful. When this occurs, it is necessary to construct a master model that includes all of the projects. Some of the auxiliary projects may not come into being for several years after the main investment is made, and may or may not produce a new positive cash flow. The master model in simple form may take on the appearance shown in Figure A-7 if individual projects of the types (a), (b), and (c) above are assumed (the figures do not add up—only format is demonstrated).

Project

NPV

0

1

2

3

4

5

...

15

(a)

100

(30)

(2)

14

14

13

13

40

(b)

40

—

—

(15)

5

5

5

20

(c)

(26)

—

(2)

(2)

(4)

(4)

(4)

(10)

TOTAL

114

(30)

(4)

(3)

15

14

14

(50)

Figure A-7: Master project.

If the three projects are interrelated, they should be projected as a single entity. In our example, (a) is assumed to be a major facility that to be successful needs (b) added in three years as supporting facilities; (b) would have no basis for existence if (a) were not created. Project (c) may possibly be identified as a new computer/information system that will produce only costs, but would not exist if (a) and (b) were not created. All costs and all benefits for all corollary investments need to be projected as far into the future as possible to get a true evaluation. Investment evaluations that are made of a project with all the certainty of a DCF percentage can be grossly misleading if the supporting investment of satellites is not taken into account. Actually, these are not separate investments. There is only one—Project abc. The evaluation has to be of the new single entity. The postaudit can be of only the conglomerate single entity (abc).

Projects of the cost-savings category are generally easiest to identify and evaluate. There are relatively clear-cut choices: Invest $40,000 today for new labor-saving machines that will reduce labor costs $12,000 per year; the machines will last eight years, and quality of performance will be unchanged. Determine the NPV and/or DCF-ROR and accept/reject. Such investment opportunities constantly arise, but it is almost impossible to project them as part of a master project. As a result, such investments are evaluated as isolated investment opportunities that may occur in three years, or eight years, or never. When they occur, if of major proportions, they affect the potential return on the total investment.

A cost-incurring project, such as spend $100,000 to prevent air pollution or be closed up, is one of the few black-and-white decisions a manager faces. Ideally it would be expensed. It may have to be capitalized and written off and in addition have annual related operating expenses. This nondiscretionary investment falls into the same general category as a support project. The cash flow is always negative and must be included as an integral part of the master investment. A large enough commitment may sharply reduce the original projection, and a revision may be necessary.

On the basis of the techniques for evaluating planned capital investment, it is now possible to move to the methods of selecting among projects. As noted previously, in theory, selecting among projects is easy. Invest in anything that, when discounted at the appropriate marginal rate, will yield a positive NPV. Practically, for many reasons, there are constraints on capital in the minds of most managers. Let us look at the project selection problems that are involved for projects under consideration in a particular risk category when there is a limit on capital.

We have selected the NPV method as the best approach to analyze proposed projects of varying lives. Comparing projects under the DCF-ROR method can be misleading because of the different life factor and the reinvestment factor inherent in each ROR. Excess NPV avoids this difficulty. When the various projects are converted into a profitability index, selection is further facilitated. The profitability index is the ratio of the NPV to investment. For example:

In selecting projects when a limit is imposed upon the amount available for investment, we look for the combination that will maximize combined NPV without exceeding the imposed limit. We know that we have reached this goal when we can no longer increase the combined NPV by substituting one project for another and still satisfy the constraint.

A way to achieve a satisfactory combination of projects is through trial and error. As a guide, we can use the profitability index (see Figure A-8). However, such ratios are not foolproof. This is illustrated where there are three possible projects requiring a total of $1,500 in initial outlays, but where $1,000 is the imposed limit.

Project

NetPresentValue

[ ]

Investment:CashOutlay

[=]

ProfitabilityIndex

A

$1,000

$600

1.67

B

700

500

1.40

C

500

400

1.25

Figure A-8: Profitability index.

The choice is between investment in A + C (cash outlay $1,000) or investment in B + C (cash outlay $900). Since A + C have a combined greater NPV than B + C ($1,500 vs. $1,200), A + C should be selected even though C's ratio (1.25) is less than B's ratio (1.40). Such differences are common. The profitability index must always be used judiciously. When there are numerous projects to choose among, the combining process becomes more difficult.